Chapter 10 (The Monetary System) Flashcards
Whether you pay by cash, cheque, or debit card, the restaurateur is happy to work hard to satisfy your gastronomical desires in exchange for these pieces of paper and plastic that, in and of themselves
are worthless
Without money, people would have to rely on
barter-the exchange of one good or service for another-to obtain the things they need.
An economy that relies on barter will have trouble allocating its scarce resources efficiently. In such an economy, trade is said to require the
double coincidence of wants-the unlikely occurrence that two people each have a good or service that the other wants
As money flows from person to person in the economy, it facilitates production and trade, thereby allowing
each person to specialize in what he or she does best and raising everyone’s standard of living
Economists, however, use the word in a more specific sense: Money is
the set of assets in the economy that people regularly use to buy goods and services from other people
According to the economist’s definition, money includes only those few types of wealth that are
regularly accepted by sellers in exchange for goods and services.
Money has three functions in the economy:
It is a medium of exchange, a unit of account, and a store of value. These three functions together distinguish money from other assets in the economy, such as stocks, bonds, real estate, art, and even
hockey cards.
A medium of exchange
is an item that buyers give to sellers when they purchase goods and services.
A unit of account
is just the money as a unit of measure to have a balanced exchange
A store of value is
an item that people can use to transfer purchasing power from the present to the future
The term wealth is used to refer to the total of all stores of value, including both
money and nonmonetary assets
Economists use the term liquidity to describe
the ease with which an asset can be converted into the economy’s medium of exchange. Because money is the economy’s medium of exchange, it is the most liquid asset available
When money takes the form of a commodity with intrinsic value, it is called
commodity money. The term intrinsic value means that the item would have value even if it were not used as money. One example of commodity money is gold.
When an economy uses gold as money (or uses paper money that is convertible into gold on demand), it is said to be operating under
a gold standard.
Money without intrinsic value is called
fiat money. A fiat is simply an order or decree, and fiat money is established as money by government decree
the quantity of money circulating in the economy, called the
money stock, has a powerful influence on many economic variables
The most obvious asset to include is currency
the paper bills and coins in the hands of the public. Currency is clearly the most widely accepted medium of exchange in our economy.
Gold not other substances because
we want something that won’t be quickly destroyed, something that won’t destroy us and something that isn’t volatile
To measure the money stock, therefore, you might want to include demand deposits
balances in bank accounts that depositors can access on demand simply by writing a cheque or using a debit card
Although at first this argument may seem persuasive, credit cards are excluded from all measures of the quantity of money
The reason is that credit cards are not really a method of payment but a method of deferring payment.
When the time comes to pay your credit card bill, you
will probably do so by writing a cheque against your chequing account. The balance in this chequing account is part of the economy’s stock of money
Even though credit cards are not considered a form of money
they are nonetheless important for analyzing the monetary system.
Thus, the introduction and increased popularity of credit cards may
reduce the amount of money that people choose to hold.
Whenever an economy relies on a system of fiat money, as the Canadian economy does, some organization must be responsible for controlling the stock of money
In Canada, that organization is the Bank of Canada.
The Bank of Canada is an example of a central bank
an institution designed to control the quantity of
money in the economy
Other major central banks around the world include the
Bank of England, the Bank of Japan, the European Central Bank, and the Federal Reserve of the United States.
Until the Great Depression of the 1930s, Canada had no central bank.
Bank notes were issued by the Department of Finance and by the large commercial banks
The monetary system was regulated by the Department of Finance, acting in concert with those large commercial banks. The gold standard
ensured that bank notes could normally be exchanged for a fixed quantity of gold. The economic problems of the Great Depression, and the need to control the
quantity of fiat money when the gold standard collapsed, led the government to set up a royal commission to study the issues.
The commission recommended that a central bank be established. As a result, in 1934 Parliament enacted the Bank of Canada Act, which laid down the responsibilities of the Bank of Canada. The Bank was established in 1935 and nationalized in 1938, so it is now owned by the
Canadian government.
Commercial banks
are owned by their individual shareholders
The Bank of Canada has four related jobs. The first is to issue currency.
The second job is to act as banker to the commercial banks. The third job is to act as banker to the Canadian government.
The Bank of Canada’s fourth and most important job is to control the quantity of money that is made available to the economy, called the
money supply
Decisions by policymakers concerning the money supply constitute
monetary policy
The Bank of Canada has the power to increase or decrease the
number of dollars in the economy.
Although in practice the Bank of Canada’s methods of controlling the money supply are more complex and subtle than this, the helicopter vacuum metaphor is a good first approximation of the meaning
prices rise when the government prints too much money. Another of these ten principles is that society faces a short-run tradeoff between inflation and unemployment
the Bank of Canada’s policy decisions have an important influence on the economy’s rate of inflation in the long run and the
economy’s employment and production in the short run.
Recall that the amount of money you hold includes both currency (the bills in your wallet and coins in your pocket) and demand deposits (the balance in your chequing account)
Because demand deposits are held in banks, the behaviour of banks can influence the quantity of demand deposits in the economy and, therefore, the money supply
Whenever a person deposits some money, the bank keeps the money in its vault until the depositor comes to withdraw it or writes a cheque against his or her balance.
Deposits that banks have received but have not loaned out are called reserves
In this imaginary economy, all deposits are held as reserves, so this system is called
100 percent reserve banking.
We can express the financial position of First National Bank with a
T-account, which is a simplified accounting statement that shows changes in a bank’s assets and liabilities
On the left-hand side of the T-account are the bank’s assets of $100 (the reserves it holds in its vaults)
On the right-hand side of the T-account are the bank’s liabilities of $100 (the amount it owes to its depositors). Notice that the assets and liabilities of First National Bank exactly balance.
if banks hold all deposits in reserve,
banks do not influence the supply of money.
Of course, First National Bank has to keep some reserves so that currency is available if depositors want to make withdrawals. But if the flow of new deposits is roughly the same as the flow of withdrawals, First National needs to keep only a fraction of its deposits in reserve. Thus, First National adopts a system called
fractional-reserve banking.
The fraction of total deposits that a bank holds as reserves is called the
reserve ratio. This ratio is determined by a combination of government regulation and bank policy. As we discuss more fully later in the chapter, some central banks place a minimum on the amount of reserves that banks hold, called a reserve requirement. In addition, banks may hold reserves above the legal minimum,
called excess reserves, so they can be more confident that they will not run short of cash
Let’s suppose that First National has a reserve ratio of 10 percent. This means that it keeps 10 percent of its deposits in reserve and loans out the rest. Now let’s look again at the bank’s T-account:
First National still has $100 in liabilities because making the loans did not alter the bank’s obligation to its depositors. But now the bank has two kinds of assets: It has $10 of reserves in its vault, and it has loans of $90. (These loans are liabilities of the people taking out the loans but they are assets of the bank making the loans, because the borrowers will later repay the bank.) In total, First National’s assets still equal its liabilities
Once again consider the supply of money in the economy. Before First National makes any loans, the money supply is the $100 of deposits in the bank. Yet when First National makes these loans, the money supply increases. The depositors still have demand deposits totaling $100, but now the borrowers hold $90 in currency.
The money supply (which equals currency plus demand deposits) equals $190. Thus, when banks hold only a fraction of deposits in reserve, banks create money.
note that when First National Bank loans out some of its reserves and creates money,
it does not create any wealth.
At the end of this process of money creation, the economy is more liquid in the sense that there is more of the medium of exchange,
but the economy is no wealthier than before.
The creation of money does not stop with First National Bank. Suppose the borrower from First National uses the $90 to buy something from someone who then deposits the currency in Second National Bank. Here is the T-account for Second National Bank:
After the deposits, this bank has liabilities of $90. If Second National also has a reserve ratio of 10 percent, it keeps assets of $9 in reserve and makes $81 in loans. In this way, Second National Bank creates an additional $81 of money. If this $81 is eventually deposited in Third National Bank, which also has a reserve ratio of 10 percent, this bank keeps $8.10 in reserve and makes $72.90 in loans. Here is the
T-account for Third National Bank
The process goes on and on. Each time that money is deposited and a bank loan is made, more money is created. How much money is eventually created in this economy?
Original deposit $100.00
First National lending $90.00 [= 0.9 x $100.00]
Second National lending $81.00 [= 0.9 x $90.00]
Third National lending $72.90 [= 0.9 X $81.00]
Total money supply = $1000.00
